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Will the Fed walk the hawkish talk?

akrainer's Photo
by akrainer
Sunday, Jan 09, 2022 - 11:47

On Tuesday last week (4 January), the markets got spooked by the released minutes of a Federal Reserve Open Market Committee’s meeting held three weeks prior. What was the fuss all about? Well the minutes indicated that the Fed seems to be inclined to envision starting to prepare to begin planning to initiate raising interest rates sooner and more aggressively than previously thought and to “normalize” their balance sheet beginning already toward the end of this year.

FOMC minutes stated that “Participants generally noted that, given their individual outlooks for the economy, the labor market, and inflation, it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated,” and that, “Some participants noted that it could be appropriate to begin to reduce the size of the Federal Reserve’s balance sheet relatively soon after beginning to raise the federal funds rate…” Those remarks hardly indicate readiness for a decisive turn and it remains to be seen whether the Fed will actually walk the timid hawkish talk.

As all the G7 central banks, the Fed is out of ammunition and all they can do now is buy time with an ever accelerating monetary inflation / QE / money printing. Sure, they might like to reverse the QE policy and normalize things but apart from discussions in Committee meetings and their “moral suasion” which is having a rapidly diminishing impact, the odds of them actually making good on these intentions are close to nil.

In 2016, from a much less unfavorable starting point the Fed initiated a cycle of raising the Fed Funds Rates and unwinding its balance sheet (the famous ‘tapering’). But by September 2019 this nearly collapsed the banking system and the resulting Repocalypse prompted the Fed to turn on a dime and rapidly reverse course back toward zero interest rates and aggressive balance sheet expansion. Note, this reversal started well before the Covid 19 pandemic provided the smokescreen to dramatically enhance that policy. As Morgan Stanley’s Chief Cross-Asset Strategist Andrew Sheets wrote with appropriate skepticism, “… it would seem for the moment that central banks are increasingly comfortable pushing a more hawkish line until something pushes back.”

 

So, what can the Fed do differently today that it was unable to do in 2016-2019? Other than more wishful thinking, the answer is, pretty much nothing. Printing money is it. Thus, last Tuesday, we’ve had the news event and the market’s initial reaction. What we’ll see going forward will be determined by the way market participants collectively digest the Fed’s moral suasion and adjust their expectations about future developments, and their expectations will indubitably be informed by the Fed’s past conduct. One River Asset Management’s Eric Peters noted that, “for all the portfolio reshuffling and stop-loss selling, not a single market participant doubted that the Fed stands ready to bail everyone out in a market crash. Such conviction is well-supported by decades of repeated behavior from our accommodating central bank.”

What could push back against the Fed’s ostensible hawkishness? With new new SARS CoV-2 scariants appearing on cue and with geopolitical tensions continuing to escalate, we could have another dovish turn in Fed talk and further delaying of policy “normalization.” The ongoing energy crisis or a deeper market correction could also prompt a change of heart.

The big question is, where do the markets go from here? That could be impossible to predict as we are entirely in uncharted waters. Unthinkable should be thinkable and we shouldn’t be surprised even to see a Weimar / Zimbabwe / Venezuela – style continued exponential growth in asset valuations, coupled with an accelerating inflation.

But rather than trying to predict the outcome, I believe the most reliable way to navigate the events is by watching the trends as they unfold. Large-scale price events invariably unfold as trends that usually span weeks, months and even years and the most reliable way to capture value from such trends is by using systematic trend following strategies.

Even for committed ‘fundamentalists’ among the investors, they should at the very least be regarded as valuable second opinion. As Paul Tudor Jones conceded, “One thing I have learned over time is the best thing to do is let market price action guide your decision-making and then try to understand the fundamentals as they become more evident and comprehensible.”

 

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